How Not to Fight Income Inequality

Trying to combat income inequality through mandated wage compression is not just an odd preference. It is a mistake, as Mexico's president-elect, Andrés Manuel López Obrador, will find out in a few years, after much damage has been done.

CAMBRIDGE – Suppose two people hold different opinions about a policy issue. Is it possible to say that one is right and the other wrong, or do they just have different preferences? After all, what is the difference between an odd preference and a mistake?

A preference influences a choice that is expected to deliver the goal the chooser wants to achieve. A mistake is a choice based on a wrong belief about how the world works, so that the outcome is not what the chooser expected. Unfortunately, this may be a costly way to learn. It also may be inconclusive, because it is always possible to attribute the mistake’s bad consequences to other factors.

A case in point is the decision by Mexican President-elect Andrés Manuel López Obrador (AMLO), to lower the salaries of the higher echelons of the civil service, including himself, capping them at $5,707 per month. Many greeted the decision, announced in July, with glee. It showed that AMLO was committed to fiscal austerity and income equality.

But what appears to be a well-articulated preference will prove to be a serious mistake. Unfortunately, AMLO will find out only in a few years, by which point the damage inflicted on Mexico will be huge.

Interfering with market prices to achieve fairness – an idea that harks back to St. Thomas Aquinas and even Aristotle – is probably one of the worst economic policies ever. Governments in many countries regularly set prices – especially for energy, foreign exchange, or credit – artificially low, leading predictably to under-investment and shortages. Venezuela is an extreme case that dramatizes the consequences. But are public sector wages another example of this practice?

The answer is more nuanced. In general, governments pay their employees significantly more on average than the private corporate sector, because government services such as education, health care, justice, and administration are on average more skill-intensive. As a result, government employees have significantly higher levels of schooling – four more years, on average, in Mexico. But even controlling for this, a study by the CAF Development Bank showed that average wages are higher in the public sector in Latin America. In Mexico, government employees’ wages were about 13.5% higher than private-sector wages in 2012.

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The same study also showed that wages in the public sector are significantly less unequal than in the private sector. This means that while the public sector pays more than the private sector at the median, the situation is reversed at the top end of the pay scale. This was not the case in Mexico, where the public-sector premium fell to zero but did not become negative. AMLO now wants to join the rest of the continent.

The compressed wage structure that AMLO will introduce typically means that, at the low end, public sector jobs are highly coveted: they offer higher pay, shorter hours, better benefits (such as pensions and health insurance), and greater stability. Turnover tends to be very low and political parties try to make sure that jobs go to their supporters.

By contrast, at the high end, governments often struggle – and often fail – to attract and retain talent. As a consequence, government agencies never develop the deep knowledge, institutional memory, and competence they need to perform their functions effectively. Central banks, with their separate pay scale, often are the exception that proves the rule.

To cope with this competence deficit in their client countries, multilateral development institutions, such as the World Bank, often create project-management units run by higher-paid consultants, and dismantle them when the project is completed. These workarounds are not ideal, because they don’t develop long-term institutional capabilities. To a large extent, Mexico had been an exception, because it paid salaries that enabled the government to attract and retain highly educated career bureaucrats.

Politicians such as AMLO should ask themselves why profit-maximizing firms believe that they cannot boost their bottom lines by saving on senior management salaries. As firms compete for skills, they bid up wages, leaving the public sector with less qualified employees. Clearly, many young people want to work for the government out of an idealistic commitment to public service and as a learning opportunity. But when public-sector wages are depressed, they usually do so for just a few years, before they start a family, and certainly not for a lifetime, which is what many complex public-sector agencies often require.

Is this a problem? Good governments rightly want major firms and the rich to pay their fair share of taxes. They want corporations not to abuse their market power, pollute the environment, or sell unsafe products. They want to protect people from criminal gangs. They want the currency to be stable and financial institutions to be safe, so that people’s savings are secure and taxpayers do not have to bail out the banks. They want public projects that are well conceived and structured, and procurement processes that protect the budget from opportunistic or corrupt suppliers. They want oil and mining concessions to be allocated efficiently and to maximize government revenue.

AMLO’s decision to lower the wages of public employees has already led many high-ranking officials to seek employment elsewhere. Those who are entitled to early retirement are taking it, rather than waiting for AMLO’s cut. Many in AMLO’s own party will celebrate, because they can fill the vacancies with loyalists. But these benefits will come at the cost of a less capable state that is less able to deliver on AMLO’s most cherished goals.

Trying to achieve greater equality through mandated wage compression is not just an odd preference; it is a mistake. It will deliver a state less able to contribute to a more just society.

Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School.

"But when public-sector wages are depressed, they usually do so for just a few years, before they start a family, and certainly not for a lifetime, which is what many complex public-sector agencies often require."Currently, the only sector with job stability in Mexico is the public sector, even for top management and sectors with higher education, factors that weigh more than a good salary with a depressed domestic economy."Tax collectors, regulators, and prosecutors need adequate resources to win their difficult battles."The collection of taxes has little to do with the people in charge while the laws oblige small companies to subsidize large companies, in addition to being discretionally condoned (mexican crony capitalism).

Don't lower their salaries; make them earn them. "Overmanned, overpaid and underperforming" could be ascribed to the civil services in all too many countries - and at all levels of public administration.

Possibly. But as others have pointed out, sky-high salaries do not guarantee quality. And high-quality people might not demand high salaries. Surely the ideal office-holder would be someone who does the job for the satisfaction of doing it well, and can manage without a garage-full of gold-plated Ferraris or other useless status symbols. Paying a bit less and promoting people from the ranks would seem to be a good way to find such people.

"Maybe you would like to read...": that article describes a common phenomena. In the last year before elections a president will do everything to stimulate the economy to make his party look better in the elections. And a smart president will introduce painful reforms in his first year of office. Those will in the short term depress the economy and cause in the longer term growth.

Hi, Ricardo. My humble opinion: You have some good points, but for beginners I believe you should have focused on two premises: 1) Mexico's economy (the people, not the markets) has been in dire straits for 3 decades due to corruption and impunity; and 2) It has always had an unsustainable burocratic payroll. At this point in time, Mexico needs an 180 degree turnaround, no less. That takes balls, believe me!!! I admire AMLO's intent in trying, to say the very least. We simply cannot continue along this path. I would advise you to give the man the benefit of the doubt and if after a reasonable period of time, then you might wish to publish another opinion. I will look foward to it.

"Interfering with market prices to achieve fairness – an idea that harks back to St. Thomas Aquinas and even Aristotle – is probably one of the worst economic policies ever."

Oops, did I just stumble into Reason.com? This neoclassical extremism really does border on libertarianism. The idea that the holy market can always be assumed to deliver maximally efficient and fair outcomes is intellectually vacuous, no matter how many philosophers you name-drop. If you're pulling out the Venezuela comparisons when confronted by a policy of wage compression, that may be a hint that you're deep in ideology.

Put another way: Do you oppose the minimum wage as well? Collective bargaining? Carbon taxes? Anti scalping laws? Etc. These are all state interferences with market prices, no?

The author comments on high salaries as an incentive to retain talented individuals on a long-term basis and consequently develop knowledge and institutional advancement. He fails to mention that in Mexico, government officials get shuffled around different departments after almost every election or even sooner, in case of a trending scandal, which turns out to be quite often. Therefore, even without the salary cap the benefits of attracting talented people to high paying positions is not maximized, this is assuming actual "talented people" end up on those positions...cough cough Chuayfett, Osorio Chong et al. To conclude, the dismal predictions, nay, speculations of the author hinge on the basis that the current system functions just as an ideal abstraction of the capitalist reward system, sadly, it does not.

I'm building a house in Jalisco and find that the economy at the Municipal (US/UK 'county') level works, but at an early 20th century level. Maestro masons make mas o menos US$600/mo, and the helpful and competent government clerks sometimes half that. About 15% of their US counterparts. Both national cohorts should be replaced by technology, and social relations and resources optimized in terms Ricardo apparently could not anticipate.

actually, the rule should be: you can try things as long as you are willing to admit, at the very beginning, that you may be wrong in your assertions and you will withdraw your actions if the reality proves you to be wrong.

The real problem is with people who fervently believe that they, and they alone, know how the world works. For such people, when the reality squeaks, it is too bad for the reality. We just have to try harder and, typically, with greater violence. Triumph of the will, etc.

Remember this: there is a reason that he won an election. The present reality is not working so well for too many in Mexico.

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